High-frequency trading Better than its reputation?

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High-frequency trading

Better than its reputation?

Berlin, 8. März 2011

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Key questions

 What is high-frequency trading (HFT)?

 What is the economic contribution of HFT?

 Is HFT responsible for violations of market integrity and/or for systemic risks?

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Agenda

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Hierarchy and definitions of terms

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Algorithmic trading and High-frequency trading in detail

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Economic assessment: Impact of HFT on market quality

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AT

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1 Hierarchy and definitions of terms

AT and HFT are frequently mixed up in the public debate

Algorithmic trading

The use of computer algorithms to automatically make certain trading decisions, submit orders, and manage

those orders after submission.

(Hendershott and Riordan 2009) (Hendershott and Riordan, 2009)

S b f l i h i di h l b f

High-frequency trading

Subset of algorithmic trading where a large number of

small-in-size orders are sent into the market at high speed, with round-trip execution times usually

measured in milliseconds. (Brogaard, 2010)

Subset of high-frequency trading where a select group

Flash trading

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of trading firms, whom the exchanges allow to see

orders a split second before the rest of the market, gain a significant advantage over other market participants

Ultra-HFT

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HFT

AT

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1 Hierarchy and definitions of terms

HFT vs. AT and traditional long-term investing

High

Traditional

Execution

long-term investing

latency _{Algorithmic or electronic trading (execution)}

Low

High-frequency trading

Short Long

Position holding period

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2 HFT and AT in detail

Algorithmic trading strategies

Name Description of strategy

Name Description of strategy

Trade execution algorithms

Designed to minimise the price impact of executing trades of large volumes by ‘shredding’ orders into smaller parcels and slowly

releasing these into the market releasing these into the market.

Strategy

implementation

Designed to read real-time market data and formulate trading signals to be executed by trade execution algorithms. This may

p e e tat o algorithms

s g a s to be e ecuted by t ade e ecut o a go t s s ay involve automatically rebalancing portfolios when certain pre-specified tolerance levels are exceeded, searching for arbitrage opportunities, automatic quoting and hedging in a market

maker-t l d d i t di i l f t h i l l i

type role, and producing trading signals from technical analysis.

Stealth/gaming algorithms

Designed to take advantage of the price movement caused when large trades are filled and also to detect and outperform other algorithms large trades are filled, and also to detect and outperform other

algorithmic strategies.

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Hi h f

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Name Description of strategy

High-frequency trading strategies

Name Description of strategy

Electronic

market making

Liquidity-providing strategies that mimic the traditional role

market makers once played. These strategies involve making a two-sided market aiming at profiting by earning the bid-ask spread

sided market aiming at profiting by earning the bid ask spread. This has evolved into what is known as Passive Rebate Arbitrage.

Statistical Traders look to correlate prices between securities in some way and

Stat st ca arbitrage

ade s oo to co e ate p ces bet ee secu t es so e ay a d trade off of the imbalances in those correlations.

Liquidity q y Traders look to decipher whether there are large orders existing

detection

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in a matching engine by sending out small orders (“pinging”) to look for where large orders might be resting. When a small order is filled quickly, there is likely to be a large order behind it.

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Wh

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Who are the players and how do they earn money?

Large-scale turnover of numerous positions with a small return on each turnover

 HFTs are mainly proprietary traders (own-account); HFT is usually not conducted on an agency basis (for-client).

 Segmentation of professional HFT firms: proprietary trading firms (ca 48%)

 Segmentation of professional HFT firms: proprietary trading firms (ca. 48%), proprietary trading desk of a multi-service broker-dealer (ca. 46%), or hedge funds (ca. 6%).

 All asset classes involved, extending from equities and derivatives into currencies and fixed income.

 Volume of HFT: No consistent figures on the size of HFT available

 Volume of HFT: No consistent figures on the size of HFT available (Estimations: 60-70% of US trading volume, ca. 40% in Europe).

 Prominent players: Proprietary trading firms Getco, Optiver or Tradebot, hedge p y p y g , p , g funds Citadel or Renaissance Technologies, and trading desks within

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Characteristics often attributed to proprietary HFT firms

The need for speed is paramount

 High-speed and sophisticated quantitative and algorithmic computer programs for generating, routing, and executing orders.

 Real time data analysis

 Real-time data analysis.

 Very short time-frames for establishing and liquidating positions.

V l b f t d t d d il b i f hi h ft 80%

 Very large number of trades generated on a daily basis, of which often >80% are cancelled shortly after submission.

 Ending the trading day flat (“delta-neutral”) i e without carrying significant

 Ending the trading day flat ( delta neutral ), i.e. without carrying significant, unhedged positions over-night.

 Speed matters in the absolute sense of achieving very small latencies, but even more so in the relative sense of being faster than competitors, even if only by a microsecond .

 

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3 Assessment: Impact of HFT on market quality

Impact of HFT on liquidity

Provision of liquidity and linkage of fragmented markets

 Often read argument: HFTs provide no real liquidity because they are constantly attempting to flatten their position.

 Empirical evidence however suggests that :

 Empirical evidence, however, suggests that...:

– HFTs reduce spreads.

– HFTs add substantial liquidity to the market.q y – HFTs alleviate effects of market fragmentation.

 From the academic side, there is no proof for a negative liquidity impact, but some issues still remain...:

– No market making obligation: HFTs are not obliged to provide liquidity. Size of quotes: HFTs do not contribute to market depth

– Size of quotes: HFTs do not contribute to market depth.

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Impact of HFT on the price discovery process

HFT is widely seen as beneficial

 HFTs tend to follow a price reversal strategy, driven by order imbalances, and so tend to stabilise prices.

 HFTs provide the best bid and offer quotes for a significant portion of the

 HFTs provide the best bid and offer quotes for a significant portion of the trading day (but only around a quarter of the book depth).

 Algorithmic traders’ quotes play a larger role in the price formation process g q p y g p p than human quotes.

 No proof for a negative impact on the price discovery process:

– On the one hand, price discovery benefits from market participants who quickly detect anomalies in market prices and correct them.

– On the other hand, HFT may also be distorting price formation if it creates an , y g p

incentive for natural liquidity to shift into dark pools as a way of avoiding transacting with ever-decreasing order sizes. But: no documented empirical evidence so far to support the possibility of this distortion.

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The investor perspective

Issues of fairness and investor protection

 Electronification of trading originally led to a democratisation of exchange trading: retail investors benefitted from equally quick access to markets as professionals.

 However, special arrangements to cater for the needs of HFT (i.e. proximity and co-location services to reduce latency, special trade data feeds) give

preference to those traders  possibly harms long-term investors and market preference to those traders  possibly harms long-term investors and market quality.

 (Sub-penny) Arbitrage, where ATs and HFTs buy and sell stock purely to

collect rebates, is often criticised as bringing no value to the retail / long-term investor. But: This provides liquidity (“artificial volume creation”) that would otherwise not be available, easing the pressure of supply and demand.

 Spreads that have been narrowed (and are kept narrow) by HFTs benefit both retail and institutional investors.

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The investor perspective

Issues of fairness and investor protection

0,030

Bid-Ask Spread Reduction

USD 0,015 0,020 0,025 0,005 0,010 -03 04 05 06 07 08 09

Median S&P 500 Bid-Ask Spread

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4 Review of regulatory initiatives

Regulators’ concerns

Risks for market integrity / confidence and systemic stability

 Market integrity could be endangered when technological advantage is

misused for abusive tactics (e.g., by manipulating the price discovery process through excessive order entries and/or cancellations).

 Financial markets could become exposed to systemic risks as a result of

technical vulnerability (malfunctioning algorithms), self-reinforcing strategies, and/or overload of technical systems

and/or overload of technical systems.

 Numerous regulatory investigations and initiatives are under way:

– SEC/CFTC: (Interim) “Market Event Report”SEC/CFTC: (Interim) Market Event Report .

– Netherlands Authority for the Financial Markets (AFM): HFT Report. – European Commission: Consultation to MiFID-Review.

– ESMA: Consultation announced (summer 2011). – Working Groups at IOSCO, FSB, BIS, ...

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4 Review of regulatory initiatives

How to guarantee integrity and maintain stability?

Effectiveness of proposals put forward so far is unclear

 Some proposals are conducive to the regulators’ objectives:

– Risk controls (circuit breakers) to be adopted by trading venues provided they are properly calibrated in cooperation with market participants and consistent across

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venues.

– Adoption of minimum tick sizes, calibrated by reference to price and levels of liquidity. Co location facilities to be made available on a non discriminatory basis

– Co-location facilities to be made available on a non-discriminatory basis.

 Others are unrealistic and/or will be difficult to put into practice:

Artificially limiting execution speed on trading venues – Artificially limiting execution speed on trading venues.

– Imposing affirmative obligations (enforced market maker role).

– Minimum life-time for quotes before they can be cancelled or modified.

 Regulations should not impair HFT’s liquidity provision nor push HFT to other jurisdictions or OTC.

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Michael Chlistalla

Deutsche Bank Research / Banking, Financial Markets, Regulation Taunusanlage 12, D-60262 Frankfurt am Main

T: +49-69-910-31732, F: +49-69-910-31743 [email protected]

@ www.dbresearch.de

um Quellenangabe „Deutsche Bank Research gebeten.

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